I was, until recently, Economics Editor of The Telegraph. You can find my book - 50 Economics Ideas You Really Need to Know - here.

What banks can learn from Al-Qaeda

I never thought I’d hear the Bank of England say banks should behave more like a terrorist network, but that is precisely what happened earlier today. Andy Haldane, the Bank’s Executive Director of financial stability, has proclaimed that institutions should be more like Al-Qaeda. And he is right.

The point is not that they should embark on a career of murder and destruction (some might joke that they’re already rather far down that road), but that we should be examining the way banks structure themselves just as much as how we try to restrict them to make sure they don’t create crises in the future. The speech itself is pretty long, but really should be read in its entirety by anyone interested in the area – I don’t think I have read any other more comprehensive, persuasive tours d'horizon of the whole “too big to fail” debate as this one.

"A Big World Needs A Big Bank" was the unfortunate slogan of this old Barclays ad with Sir Anthony Hopkins

For those after a shorter (but still necessarily-long) version, I’ve picked through the argument here.

Haldane has distinguished himself as one of the real stars in UK financial regulation. So seriously is he taken within the City that barely minutes after the Centre for the Study of Financial Innovation recently advertised a dinner at which he was speaking, the event was fully-booked with almost 50 of London’s leading executives keenly signing up to hear him speak. This is, one suspects, out of fear as much as admiration or curiosity: Haldane, who came up with the “doom loop” phrase we wrote about a while back, has said repeatedly that the reforms to the financial sector must be deeper and more far-reaching than those which followed the Great Depression.

The very condensed gist of this speech is effectively to examine the two broad ways of restraining banking in the future – through either a form of taxation (this could mean capital requirements and other ongoing regulations as well as actual taxes) or prohibition (which can mean simple restrictions on what a bank can do and how it should be structured). He compares the former to the Basel rules on banking and the latter to the Glass-Steagall act in the US (which split commercial and investment banks up in the 1930s), and from this comparison you can probably guess where his sympathies lie:

Glass-Steagall was simple in its objectives and execution. The Act itself was only 17 pages long. Its aims were shaped by an extreme tail event (the Great Depression) and were explicitly minimax (to avoid a repetition). It sought to achieve this by acting directly on the structure of the financial system, quarantining commercial bank and brokering activities through red-line regulation. In other words, Glass-Steagall satisfied all three robustness criteria. And so it proved, lasting well over half a century without a significant systemic event in the US.

The contrast with Basel II is striking. This was anything but simple, comprising many thousands of pages and taking 15 years to deliver. It was calibrated largely to data drawn from the Great Moderation, a period characterised by an absence of tail events – more minimin than minimax. Basel II was underpinned by a complex menu of capital risk weights. This was fine-line, not red- line, regulation. In short, Basel II satisfied few of the robustness criteria. And so it proved, overwhelmed by the recent crisis scarcely after it had been introduced.

This is what happens to banks' balance sheets when you remove the Glass-Steagall-style post-Depression prohibitions on their structure

Honestly, no connection here whatsoever

The speech kicks off with a fascinating set of calculations about how on earth one can work out how much you might try to charge banks (say, through a new financial tax) to make up for the costs they impose on society through frequent crashes. This is no easy calculation, since in the UK it could be anywhere between £1bn a year (which would more or less compensate for the cash spent by taxpayers on direct bail-outs every 20 years or so) and between £1.8 trillion and £7.4 trillion (when one takes the entire possible lost output and presumes it is permanent).

Another way of trying to work out the cost is by measuring “the (often implicit) fiscal subsidy provided to banks by the state to safeguard stability” – something we can do by simply comparing the credit ratings banks are awarded with those they would get if one assumed there was no state support (credit ratings agencies usefully provide both). The implied state support? Between 2007 and 2009 an average annual subsidy of over £50bn for the top five UK banks alone – “roughly equal to UK banks’ annual profits prior to the crisis.” Ouch.

The point from both of these calculations being that if you were to try to impose a “stability fee” on banks commensurate with the benefit of their state support, it would quite conceivably be greater than they could ever hope to earn.

The implication, and it is one which becomes clear as one reads through Haldane’s speech, is that instead one must try to find a way to overhaul the structure of banking. And this is where Al Qaeda comes along. For the terrorist group organises itself quite elaborately into a cell structure which means if one part collapses, or is compromised, there is a “firebreak” which protects the rest of the network. This point echoes one made by the Bank’s Governor, Mervyn King, in a recent speech. King avoided the Al Qaeda analogy, but then Haldane has always been one for including counterintuitive examples in economic speeches. Here’s another, the point of which is to show that in banks, as in many organisations, bigger is not always better.

Limits on the optimal size and scope of firms may be as much neurological as technological. Numbers of synapses may matter more than numbers of servers. The history of military units provides a good illustration. In Roman times, the optimal size of a military unit was 100 – hence the Roman centurion. This was the maximum number of men a general felt able to know well enough to lead and control. The constraint was neurological.

Two millennia have passed. Extraordinary advances have been made in military telecommunications technology. And the optimal size of the military unit in the US army today? Just under 100 people. The number of relationships humans are felt able to maintain is believed to lie below 150 – so-called Dunbar’s Law. For most of us, it is single-digits. That number has been roughly the same since the dawn of time, despite the extra-ordinary recent advance of technology and social networks. As Nicholas Christakis has observed, Facebook “friends” are not really your friends.

With hindsight, this crisis has provided many examples of failures rooted in an exaggerated sense of knowledge and control. Risks and counterparty relationships outstripped banks’ ability to manage them. Servers outpaced synapses. Large banks grew to comprise several thousand distinct legal entities. When Lehman Brothers failed, it had almost one million open derivatives
contracts – the financial equivalent of Facebook friends. Whatever the technology budget, it is questionable whether any man’s mind or memory could cope with such complexity.

It is an important lesson. Undoubtedly one of the problems in the financial crisis was that certain institutions (RBS being the perfect example) became so big that they were frankly unmanageable – a fact not helped by the fact that Sir Fred Goodwin distinguished himself as such a poor manager. This ought to be a lesson for all industries. A merger of two companies ought to be pursued because there is a definite long-term opportunity to make the combined business more profitable. But there is mixed evidence to suggest that mergers do this – instead they often enrich the shareholders in the short term but weaken the companies – and eventually the stockholdings – in due course.
Now, in banks this was particularly disastrous because of the damage they could inflict on broader society.

Haldane’s point is, in short: “Bigger and broader banking does not obviously appear to have been better, at least in a risk sense.”

His conclusion is that there is likely to be a size beyond which a bank becomes both inefficient and dangerous, and his hunch is that this threshold may be $100bn:

Experience suggests there is at least a possibility of diseconomies of scale lying in wait beyond that point. Conglomerate banking, while good on paper, appears to be more mixed in practice. If these are not inconvenient truths, they are at least sobering conjectures. They also sit awkwardly with the current configuration of banking.

In 2008, 145 banks globally had assets above $100bn, most of them universal banks combining multiple business activities. Together, these institutions account for 85pc of the assets of the world’s top 1000 banks ranked by Tier 1 capital…The same 145 institutions account for over 90pc of the support offered by governments during the course of the crisis.

For anyone paranoid that the regulators will be out to get them, the speech will make sobering reading. My inclination is to agree wholeheartedly with Haldane that in the end only a structural reform in the banking system will be enough to make it safe. But I don’t think this need be limited to the question of restricting size and activity. I strongly suspect that one solution is to make banks rather more like partnerships than limited liability companies: at least ensuring that their directors, if not all shareholders, must bear more of the costs in the event of its collapse.

However you do it, there is more to be done to overhaul the ownership hierarchy for financial institutions (Paul Tucker also pointed in this direction in a recent speech, effectively signalling that banks’ debtholders must not be allowed to get off so easily in the event of a collapse). What worries me is that we have still seen so little decent research on these more radical structural proposals, and, more deeply that they seem so far from what the international regulators in Basel are likely to conclude when they come up with Basel III.
Anyway, the final concluding word of this (I apologise) very long blog, must go to Haldane:

Tail risk is bigger in banking because it is created, not endowed. For that reason, it is possible that no amount of capital or liquidity may ever be quite enough. Profit incentives may place risk one step beyond regulation. That means banking reform may need to look beyond regulation to the underlying structure of finance if we are not to risk another sparrow toppling the dominos.